At SprinkleBit, we feel that you should be educated not just in investing for retirement, but all the other ways in which you can allocate your assets. Owning a mortgage can be a big investment, and we feel that it's important for homeowners or prospective homeowners to know the ins-and-outs—as well as the risks—of acquiring a home loan.
The following is a guest post from Scott Sheldon, a senior loan officer and consumer advocate based in Santa Rosa, CA. More information on Scott can be found in his bio below.
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Many of the mortgages being made today contain higher loan-to-values. These loans contain inherent
"risk-based pricing" which causes the rates to change.
What is loan-to-value anyway?
The loan-to-value
(LTV) is defined as the amount of money you're borrowing against the value of the property expressed as a percentage of the transaction as a whole.
For example borrowing $200,000 against a property worth $300,000, translates to a 67% loan-to-value.
Loan Amount ÷ property value= LTV
How loan-to-value affects the risk the lender takes in making the mortgage loan
Risked-based pricing can be summarized in this correlation:
The bigger loan amount relative to the valuation of the property, the higher the risk.
The smaller loan amount relative to the valuation of the property, the less risk
The cost of risk on a higher loan to value loan is paid by either by the lender or the consumer.
The risk does not just evaporate. The cost of risk in making a mortgage loan boils down to how the amount of money being borrowed affects the interest rate. Everyone wants to minimize risk as much as possible.
The lender minimizes risk by offering the consumer a higher interest rate. As a result of the higher risk, they want to be paid accordingly.
The borrower minimizes risk by taking a lower interest rate and depending on the nature of the of the loan program and pays any fees to Fannie Mae or Freddie Mac in exchange for taking on the risk the lender otherwise would incur.
Or......
Lender and consumer mutually agree to share the risk by taking a middle of the ground interest rate.
Put another way, it's not the highest interest rate, nor the lowest rate, but a
reasonable rate taking all of the following into account:
- Loan Program
- Loan Amount
- Property Type
- Credit Score
- Occupancy
To illustrate, take a look at some examples below of how a higher loan to value on a conventional purchase and on a conventional refinance could affect the interest rate:
Purchase Transaction
Property Value $400,000
Down Payment 5.0%
Interest Rate 3.75%
Loan To Value 95.00%
Loan Amount $380,000
Payment (P&I) $1,760
This conventional loan scenario also would include mortgage insurance as a result of the higher loan-to-value, lower down payment type financing. The cost of risk is two-fold here:
- higher mortgage insurance
- .25% higher in rate.
Refinance Transaction
House Value $325,000
Loan Amount $380,000
Interest Rate 4.00%
Loan to Value 117.00%
Loan Amount $380,000
Payment (P&I) $1,814
The loan-to-value on this refinance is under the common Harp 2 Refinance program that allows homeowners to refinance without a loan-to-value restriction. The risk-based pricing remains the same. You'll notice another .25% higher in rate on a higher loan-to-value refinance transaction.
As a general rule of thumb expect changes to rate on conventional loans 75% loan to value or higher on purchase loans and refinance loans.
How to Reduce the Cost of Risk over the Life of the Loan
- Reduce the loan amount/borrow less
- If you have the cash, invest the cash into the transaction to recuperate your principal balance pay down by the interest rate and mortgage payment savings over time
- Change loan programs-conventional loans contain the highest risk based pricing, consider a more flexible loan such as government financing
- Finance the cost of reducing the interest rate over the life of the loan so long as you have a 1-2 year breakeven time by holding the loan/keeping the property
